April 27, 2007

Does Free Trade Bring Lower Prices?

Daniel Drezner has some nice things to say about me and my blog, but then takes me to task for understating the gains from free trade in a recent entry. He writes:

In focusing strictly on the employment effects, however, Rodrik elides the biggest gain from trade -- lower prices.

Since Drezner’s point reflects a common misunderstanding about the effects of trade, it is worth some explication.

Advocates of globalization love to argue that free trade lowers prices, and the argument seems sensible enough. Think of all the cheap goods from China that we can buy at Wal-Mart.But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors).When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up!Consumers are better off to the extent that their consumption basket is weighted towards importables, but we cannot always rely on this to be the case.

Consider your typical Argentinian for example, who consumes a lot of wheat and beef. Since these are export products for Argentina, free trade implies a rise in the relative price of the Argentine consumption basket. (The gains from trade are still there, of course, but they derive from the usual allocative efficiency improvements, not from lower prices across the board.) And in the U.S., the Wal-Mart effect has to be qualified to take into account the fact that the relative price of the goods that the U.S. exports (including for example agricultural commodities) is higher than it would have been absent trade.Similarly, when the U.S. gets better market access abroad for its agricultural exports (a key demand under the Doha round), you can be sure that this will raise domestic prices for these goods, not lower them.

Of course, if you are running a huge trade deficit like the U.S., you can have cheaper prices all around—for all to go on a consumption binge as long as the party lasts.But this is hardly the argument we make when we teach the benefits of free trade.

Postscript: It is interesting that many of the commentators below have appealed to scale economies as an explanation of how production costs and prices can fall all around as market size expands thanks to trade. Yes, this is a possibility. But scale economies raise a whole set of new conundrums (which is why I had stuck with the standard comparative advantage story). In particular, since scale economies are not compatible with perfect competition, we find ourselves in a second-best world with all kinds of strange possibilities. Opening up to trade can leave some countries worse off, and in general trade-distorting policies like tariffs and subsidies can make individual countries better off. So be careful how you describe the world we live in...

Comments

Or put another way if trade brings more efficiency real income goes whether because the price level goes down or nominal income goes up and prices are constant. Whose income remains a question if the efficiency gains go mostly to the already well off then income inequality increases. This seems to have occurred, not to say that the efficiency gains are primarily due to trade.

Argentina is a very good real life example. In March 2006, the Peronist government of Argentina suddenly prohibited exports of beef. The announced purpose, to reduce the price of beef to the Argentinian consumer, and assure a good supply of this all important commodity to the Argentine voter.

Caterpillar has plants in the US and China, so they aren't the best example for me to use, but I'll use it anyway. Just pretend that they don't have any overseas plants, and that they wouldn't ever open overseas plants.

Under such a scenario, under an increase in trade, and assuming Caterpillar is on the winning side in its industry, then they export more construction and mining vehicles etc.

Initially under a full capacity scenario, their prices for domestic (i.e. US) sales would indeed rise. But they would also recognize (sooner or later)that their sales are going up overseas for secular reasons as the global economy expands and as they get to leverage their advantages whereas before they couldn't export to the degree they once did.

With this recognition, they would increase capacity, which is hardly a fixed level over time. So at most you get a temporary rise in the price of their goods locally, but conceivably their prices domestically might even go down (in inflation adjusted terms of course) over time thanks to increased economies of scale and a desire to preempt their global competition from getting a foothold in the US.

Similarly, when consumers purchase cheaper import goods, theyhave more money in their pocket with which to purchase more goods. To the extent that this catches producers by surprise, it results in increased prices once they hit full capacity. But they then add capacity, and prices back down again.

The labor adjusted price of goods can and does go down from trade, although depending on how the Fed reacts it may show up as a raise in wages as the Fed maintains a money supply to take into account lower prices. Alternatively it can mean deflation with sustainable nominal wages and sustainable low unemployment levels. Of course the Fed's bogeyman is deflation thanks to lessons it learned from the 30's (Germany learned the opposite lesson from that time period, that rising inflation is the bigger evil), therefore the rising overall wages scenario is more realistic.

The key is to realize that capacity isn't set in stone, it can and does increase, and if the increase is based on real secular demand as opposed to Fed induced phony demand, then the increase in capacity is a healthy thing.

If prices rise due to a real increase in demand, it induces a supply increase response which tends to bring the price back to its previous equilibrium.

If free trade expands the size of the market for domestic manufacturers, it allows better economies of scale in production. Fixed costs are distributed over more units sold. So prices can often go down both domestically and in foreign markets as the result of trade. Also, think of the free trade more broadly than just goods. Learning technologies through trade may also cause prices to go down as a result of trade without restrictions.

Rodrik is of course correct that we should always be focused on relative prices.

You guys are correct in claiming that in a simple new-trade model of the world where increasing returns drives the gains to trade (Krugman, Helpman etc vintage models) then the average productivity of factors will tend to increase as one moves down the industry's average cost curve -- if there are increasing returns.

Within the confines of the deminant neo-classical models of trade Rodrik is entirely correct to point out that the standard trade theorems (Stolper-Samuelson and the 'neo-classical ambiguity' in specific factors model) make it unambigously clear that more trade will lower real income of some people in the economy. The price of the goods that people consume can in fact up relative to their wages following trade. You'd need a heavy dose of gains from increasing returns to swamp that effect for all people.

In conclusion some relative prices fall and others rise following an opening to trade. There are winners and losers. In many cases the winners could in principle compensate the losers but we know for a fact that in practice they rarely do.

With the risk of reiterating some of what has already been said, I will take a slightly different approach to why relative domestic prices of exported goods in the long run may not go up.

I agree that supply and demand would dictate that the domestic prices of a country's exports will go up as it gains access to new markets. At the same time, unemployment will increase in those sectors in which foreign companies can produce goods at a cheaper price.

But go a step further. Now that there is a temporary higher level of unemployment, exporting industries will be able to hire more workers and at lower wage levels. This causes marginal costs to drop, resulting in increased production and lower prices.

There's also the potential for a competition -> innovation -> lower prices dynamic, though that's also well outside the standard neoclassical framework (and the effects of competition are unlikely to be linear).

I agree there can be a problems with total laissez-faire, but I think the principle of comparative advantage still does hold decently well. Here is video of three titans of international trade, Paul Krugman, Jagdish Bhagwati, and Robert Solow at Colombia.

Yes, most economists will tell you that comparative advantage holds up -- but that was Rodrik's point. A standard result (Stolper-Samuelson) under neo-classical comparative advantage is that the purchasing power of some groups (those who derive income primarily from the now less scarce factor -- labor in the USA) will fall. From their perspective the opening to trade has meant that the relative price of ALL goods has RISEN relative to their wage.
So if you want to say that Rodrik is wrong, and that there is a model in which ALL prices fall or, less demandingly, that all incomes rise, you have to make some strong assumptions about increasing returns and pro-competitive effects swamping all else.
One may decide that 'on balance' opening up to more trade is a good thing -- I fall in that category -- but people like Drezner are being too loose with words when they say that prices of goods fall across the board. They don't. Some relative prices increase, and that makes some people worse off. Rodrik is only saying, let's not fool ourselves otherwise.

"you have to make some strong assumptions about increasing returns and pro-competitive effects swamping all else"

Per my previous post, the only "assumptions" are that firms will continue to be profit seeking and that there is competition in the market place. These are driving economic forces both in the real world and in economic theory, so the claim that their effects must be "swamping" is a bit of a red herring.

There is little doubt that in the short run there is an adjustment period. But the long run net effect of increased trade is that more goods of all types are produced. This can only lead to lower prices, other factors (i.e. political) unchanged.

What I find truly interesting about free trade discussions is that people almost always use free trade between countries as examples. Most of the same arguments can be applied to competing businesses in another U.S. state, a city 100 miles away, or the neighborhood a block away. However, when you do this, the absurdity of most anti-free trade arguments quickly becomes apparent.

If there are gains from trade, and if these gains do not affect monetary policy, then trade will surely lower prices, just as an increase in productivity would lower prices. In crude terms MV=PY; if Y goes up, with no change in M and V, then P must go down. In real life, gains from trade would probably affect monetary policy but not “one for one.” That is, since policy makers probably care at least a little bit about real income, the gains from trade will make them less tolerant of inflation, given that those gains will facilitate an “acceptable” level of income at a lower price level.

KNZN. No, in a General Equilibrium model, which both the Ricardian and the HO models are a version of, there is no money (hence it makes no sense to argue about whether the price level is determined by monetary or "real" factors), and there is really no such thing as the "price level" since only relative prices are determined. Of course one can introduce money in one way or another but then... well, actually I'm not sure how the effects would play out - they could play out the way you state but in GE a lot of weird things can happen due to wealth effects.

But both the Ricardian and the HO models are stories about relative prices and Dani is right that, unless you do some extra work, it doesn't make sense to say "trade decreases the price level" since no such thing exists there.

The price level does exist provided that there is a good called money. Assume the supply of that good is inelastic, and, without cranking through the equations, I have a very strong prior belief that, except under very unusual circumstances, trade will raise the equilibrium price of that good (which is to say, lower the price level).

Which of course still begs the question of why this good called money is desired in the first place. Ok, I'll crank through the equations and see if it's possible to get weird results - though I suspect with quasi linear utility which is the standard way of modeling money, you're probably right.

to jdrietz who wrote: "Most of the same arguments can be applied to competing businesses in another U.S. state, a city 100 miles away, or the neighborhood a block away. However, when you do this, the absurdity of most anti-free trade arguments quickly becomes apparent."

IF we are talking about perfect free trade you may be correct, but real world free trade is very different from taking a US state to state/city to city comparison. There is free mobility of the population in the United States. If a certain city is losing out against competition from another city we can expect a population shift that would help to equalize relatively speaking the dynamics of each city. But real world free trade among nations doesn't allow for this population shift. For the benefits of free trade to actually lift all nations involved to an equitable economic level, national borders must be dropped. This is the reason why NAFTA will never reach the level of economic parity shared by the EU nations. I believe that before you tackle any other issue, mobility must be address if free trade is ever going to be a real alternative to traditional bilateral agreements.

Retail and end user pricing may go down for awhile utilizing Free Trade with labor being the main commodity. However when workers can not afford to buy the things they make in the supplyer nations and working poor grow larger in the consumer nations, a time comes when everything starts breaking down.

Lend Lease was real Free Trade. President Roosevelt did his magic act noting that you can not do business with people who do not have money. He just ramp up the industrial and agricultural might of the USA in a war economy. Through Lend Lease the U.S. grew the most awesome industrial might ever. Roosevelt supplied the allies with goods based on future payments. In most cases the payments never came but the U.S. became the stongest industrial power in world history. The Marshall Plan followed with local value added economies created in Europe and parts of Asia.
However, instead of following this formula , the USA chose to go another way and start moving its own factories outside of the USA in 1956 instead of growing local value added economies in the USA and abroad.

Trade became something else with the cost of labor becoming the main commodity.

Of course this will not work. You can not do business with people who do not have money. You can only exploit them.

Obviously, we need to do what we did in a war economy but do it in a peaceful environment. This means we need to practice the old biblical adage of doing to others as we would like them to do to us.

We need to do away with the gladiator raw Capitalism. History has shown it just does not workd and it breeds wars and terrorism.

I think the question is not correctly phrased but should read more like:

Of course free trade produce lower costs but, are these lower costs able to flow freely and benefit consumers through lower prices or are much of them captured by someone else?

And indeed I believe that far too much of the benefits of the free trade gets captured by other, among them all those beneficiaries of the extraordinary boom in the creation of new monopolies that are resulting from the whole intellectual property rights arrangements and that is not being sufficiently counterbalanced with measures that guarantee that those IPRs are not unduly exploited and that the sharing out of the public enforcement costs of those same IPRs is correctly done.

The efficiency of massive corporations doesn't always increase as they get bigger. As you add people to a company, it gets increasing harder to manage massive amounts of employees. Eventually efficiency of massive reproduction is counter balanced by having to manage more employees. Until computers do everything a manager can do, the counter balance will remain.

Free trade has one purpose: to balance the standard of living of all workers. Since 60-70% of workers live in poverty, these 60-70% in poverty will spread to all the corners of the world with free trade.

The only way to make a 3rd world country a 1st world nation is to balance worker rights with the business owner's rights. Economies don't develope when the workers can't get their fair share of the profit. What do all 3rd world countries have in common? Exploited workers.

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Yeah, but there's also specialization and comparative advantage, greater competition (with proper anti-trust law), and if done right, in many cases, a decrease in corruption. I realize you want to encourage greater intelligence in free trade agreements and side agreements, and greater compensation of the losers in free trade (the gainers gains are typically much greater than the losers losses, but there can be a lot of losers). But please be careful not to discourage free trade in general. A man of your expertise obviously knows the great overall benefits it brings.

Exactly. The result of freer trade in the US has been a redistribution of income though I think that the biggest redistribution has not been accross borders but within the US income distribution. Witness the increase in Jack Welsh's income from outsourcing back office operations to India. Yes the citizens of India probably realized an increase of income but Jack really made out. Your countrymen thank you Jack as salaries have decreased and the median household has not nearly increased commensurate with the fact that the median American household now has two full time workers. Thanks Jack. You are a real American as are all the politicians and pundits that supported you venally selling your countrymen down the river.

You seem to be saying that macroeconomics is independent of trade policy - "price level...being the province of macro and monetary factors". How can restriction or facilitation of trade not affect price level? If the only widget factory is in Vermont and the only frammitz factory is in New Hampshire, then doesn't the price level of widgets+frammitzes ultimately come down if there are no trade barriers between the two states? It is hard to separate scale, efficiency and specialization from the argument.

What matters to a consumer is not the absolute price of a good, or even the relative price compared to other goods. What matters is the price relative to the worker's wage. Since free trade as currently practiced (except within the EU) allows goods to freely cross borders, but leaves most workers trapped in one country, the effect on purchasing power is likely to be negative. Not always, of course (shop at Wal-Mart, as long as you still have a decent job), but it shouldn't be surprising that support for free trade is highest in those professions least subject to outsourcing (journalists, for example).

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There are countries in which the economy is highly developed and at a high level. In such countries, trade is of great benefit. But in countries where the economy is weak, I think need to think how to raise (at http://www.queentorrent.com I saw the statistics by country)

I would agree with other commenters that the government is not involved in regulating fair trade. Additionally, prices for cash crops such as coffee, cocoa, sugar and bananas are *not* regulated purely by supply and demand; for example, if you Google "Nestle price fixing" you will come up with a host of links related to 87 lawsuits now being filed against the chocolate "cartel" with charges of price fixing.

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Which of course still begs the question of why this good called money is desired in the first place. Ok, I'll crank through the equations and see if it's possible to get weird results - though I suspect with quasi linear utility which is the standard way of modeling money, you're probably right.

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